Tobacco Reporter on China's Tobacco Industry (fwd)

[Robert Weissman <rob@essential.org>]

Biggest in the World
An overview of the STMA and the Chinese cigarette industry.
By Chuck Bennett

Sanya, the southernmost city of Hainan Island, is as far south from
Beijing as you can go and still be in China. It's a small tropical resort
town touted as "China's Hawaii." Under the shade of coconut trees, Ah-Jun
sells betel nuts, fruits and cigarettes. A former farmer, she moved to the
town several years ago to make money off the tourists. "Without selling
cigarettes, how could I eat?" she asks.

Indeed, cigarettes are the bread and butter of Ah-Jun and the People's
Republic of China alike. China's State Tobacco Monopoly Administration
(STMA) contributes an estimated 12 percent to Beijing's national income,
more than any other industry. Since 1982 when the STMA was founded,
everything involving tobacco, including production, marketing, imports and
exports, has fallen under the jurisdiction of the monopoly.

Needless to say, the STMA has its work cut out. China's 350 million
smokers consumed 1.7 trillion cigarettes last year. Some estimate the
actual number to be closer to 2 trillion if unreported production,
counterfeiting and smuggling are taken into account. Either way, China's
population is lighting up. "We've got 1.2 billion people and they really
enjoy their smoke," says Xu Mingzhong, deputy director of the prosperous
Ningbo Cigarette Factory.

>From its central headquarters in Beijing, the STMA makes economic
policies for the entire tobacco industry. To implement these policies, the
STMA in 1984 created the China National Tobacco Corporation (CNTC). While
individual manufacturers and suppliers are given a degree of autonomy, all
major business transactions must be approved by the CNTC. Owned by the
state, each Chinese tobacco company pays the STMA taxes, but keeps its
individual profits. FOUR MODERNIZATIONS.

STMA's main goals are: to acquire new technology, internationalize,
diversify and consolidate.

Typically, new technology is acquired from abroad. Foreign suppliers have
been operating in China since the mid-'80s. In exchange for technology,
they are offered special access to the Chinese market. While such
agreements often favor the Chinese, they allow foreign companies to
establish the essential guanxi (relationships) for the future. Also, any
unbalanced terms are often offset by the additional business generated.For
example, international leaf merchants have entered into Compensation Trade
Agreements with the CNTC and the CNTC's China National Tobacco Import &
Export Corporation (CNTIEC). Standard Commercial and DIMON both supply
processing technology, such as threshing, redrying and packing equipment,
to Chinese companies. In exchange, the foreign merchants receive discounts
on tobacco until the value of the equipment has been realized. In these
deals, the CNTC gains access to up-to-date technology; promotes its
tobacco abroad; and does not have to spend its foreign currency reserves.

The Chinese tobacco industry has made progress on STMA's second goal,
internationalization. As of April 1999, China's year-to-date tobacco
industry trade surplus was up 35.6 percent to us$90.7 million.
International leaf merchants sell Chinese leaf abroad. China's powerhouse
Yuxi Hongta Group produces several brands of American-blend cigarettes for
export to Southeast Asia. Even domestic suppliers, traditionally thought
to lack the technical know-how of foreign companies, are exporting their
machinery and services. A representative of the Kunming Shipbuilding
Equipment Company, a large producer of tobacco-related machinery, says
that his company supplies manufacturers in Southeast Asia, especially
Vietnam and Indonesia.

China's diversification is making headway, as well. The Yuxi Hongta Group,
for example, produces more than 135 billion sticks a year, or 12 percent
of China's total. Its popular premium brand Hongtashan and medium-priced
brand Hongmei are found throughout the country. Aside from cigarettes,
Yuxi Hongta has been branching out into other business ventures. Yuxi
Hongta is involved with an automobile factory, banks, several four-star
hotels, a highway and even a hydroelectric power plant. The STMA is urging
other tobacco manufacturers to follow Yuxi's example.

At the same time, consolidation is changing the playing field. According
to the China National Tobacco Corporation Economic Center, there are 136
cigarette factories currently operating in China, compared with 180 in
1997. Of those 136, 121 are reportedly profitable. To further improve
efficiency and competitiveness, STMA aims to reduce the number of
factories to approximately 100 by early in the next century. While some
factories have undoubtedly been forced to close, others have come under
the control of other companies. Large companies like Yizhong Tobacco Group
and Yuxi Hongta Group have been incorporating smaller factories into their
operations. Sometimes, factories producing better-selling brands will
license their brands to other factories. Not everybody is excited about
consolidation. Machinery suppliers, for example, have seen a significant
drop in demand since the early '90s due to this trend. Heike Kungel,
public relations manager of the German machinery maker Hauni, states, "The
market for tobacco equipment in China will not grow in the future as
steadily as it grew in the beginning of the '90s." She says that foreign
companies that are looking for business opportunities in China will need
to practice patience.

Consolidation has affected business in other ways, too. Dickie Green,
country manager for DIMON China, points out a special problem related to
consolidation. "Many personnel that we knew were replaced with new faces
which required a period of mutual courtship. During this period, day to
day business seems to decelerate while we cultivate these new
relationships…relationships are key to China."

CENTRAL PLANNING. Obviously, central economic planning can have its share
of problems. Coordination between peasant tobacco farmers, distributors,
factories and retailers is sometimes lacking or non-existent. In other
cases, STMA policies may contradict one another.

A high-level official with the Yunnan Provincial Tobacco Monopoly
Administration (YPTMA) frankly says, "Central planning has problems.
Enterprises have no privilege to choose their own course; they must always
follow policy." As part of the STMA, the YPTMA oversees the entire Yunnan
tobacco industry, from the farmers to the factories to the exporters. The
official's main complaints concern counterfeiting, overproduction and
inter-provincial protectionism (see Tobacco and Free Trade page 40).
Interests of a province's tobacco industry can conflict with the interests
of the STMA in Beijing. R.J. Reynolds International's (HK) China
operations also fall under the jurisdiction of the STMA. "The monopoly
production quota has not allowed us significant production increases,"
says Francois Stettler, vice president, RJRI. Foreign companies' low
market share is a direct result of STMA control. The STMA severely limits
the amount of imports and production by joint ventures. STMA policies are
blamed for overproduction, as well. "In the interest of economy, too many
companies are allowed to produce too much. The interest of local tax
revenue causes overproduction," the YPTMA official explains.
Overproduction in leaf has been a problem of the past few years. The 1997
crop was estimated to total 3.3 million tons. Amazingly, the 1998 crop
dropped to an estimated 1.4 to 1.7 million tons, and China is still the
world's largest grower.

TRENDS. The lion's share of China's market is still in low-price
cigarettes. More than three-quarters of China's population are rural
farmers who simply can't afford premium brands. Lower-quality and -priced
Class D cigarettes have the highest level of production, and Class C
cigarettes have the highest sales. Low-tar cigarettes are gaining
popularity in the cities, along with several brands of cigarettes targeted
to women.

Domestic and foreign manufacturers alike are coping with overproduction
and the specter of deflation. A nationwide anti-smoking campaign is slowly
starting to grumble. In recent months, numerous newspaper editorials have
been attacking tobacco, and smoking restrictions are being enacted in
large cities. Smuggling and counterfeiting is ubiquitous. In fact, many
Chinese will tell you they prefer to buy medium-priced brands as many
premium brands are fakes.

As for the future, the YPTMA official predicts, "The STMA should continue
to strengthen its macro-control ability for preventing overproduction and
counterfeiting…prevention of counterfeiting is important to protect the
local cigarette factories' interest." Despite ongoing challenges, David
Adelman, tobacco analyst for Morgan Stanley Dean Witter, recently called
the CNTC "the most profitable corporation in the world." With 30 percent
of the world market, it is almost equal in size to Philip Morris and
British American Tobacco combined. In general, the CNTC under guidance of
the STMA has been doing an effective job of simultaneously regulating and
stimulating the industry. And for Ah-Jun in Sanya, her cigarettes, not her
coconuts, are putting rice in her pot.

Old foreigners in New China

Since the late '70s, foreign cigarette manufacturers have returned to
China. However, outside big cities it is tough to find a genuine Marlboro
or 555. Legal and genuine foreign cigarettes make up only an estimated 3
percent of China's market. While 3 percent of 1.7 trillion is still a
respectable 51 billion sticks a year, there is still room for growth.
Nevertheless, the STMA is expected to keep foreign manufacturers on tight
rein. Importation allotment, marketing and distribution are under direct
supervision of the CNTC. Around the world, R.J. Reynolds International's
(RJRI) Camel brand is regarded as a premium cigarette. Since 1988, RJRI
has been producing Camel Filters as a joint venture with the China
American Cigarette Factory in Xiamen, Fujian. Camel Filters are sold as
medium-priced cigarettes. A pack of Camel Filters averages rmb6 (us$0.73),
compared with more than rmb10 for a pack of Marlboros or Lucky Strikes.
The low price of Camels isn't part of a marketing strategy.

Francois Stettler, vice president of R.J. Reynolds International (HK)
explains, "There are historic reasons for the low price of Camels; since
they are locally produced and sold through the CNTC, we were not able to
increase the price of Camel Filters." Along with Camel brands, RJRI and
the China American Cigarette Factory produce Winston and Golden Bridge. In
addition, "We have recently introduced a new Camel Red line extension
which come in a box pack and a superior blend with a premium pricing. The
new Camel is produced in the joint venture and a new plant in Yanji,
Jilin," Stettler says.

Interestingly, Golden Bridge is priced only 1 or 2 yuan cheaper than Camel
Filters, yet Camel Filters cannot be found outside large cities. Again,
this isn't some kind of marketing strategy. "The distribution network is
run by the CNTC; they control where the product goes. It's not entirely
our decision," Stettler says.

The monopoly is also the sole importer of cigarettes. It buys foreign
cigarettes such as Marlboro or 555 on "consignment." That is, the monopoly
pays the foreign companies only for what it sells. New joint ventures
between foreign and Chinese cigarette manufacturers are banned. Currently,
only Japan Tobacco, RJRI and British American Tobacco cooperate with China
to produce domestic cigarettes. Rothmans International cooperates with the
Three Gorges Cigarette Factory in Hubei province producing cigars.
However, the cigar market in China is not yet even in its infancy and is
confined solely to the large cities.

All marketing activities are handled through the STMA's China National
Tobacco Sales & Marketing Corporation. Marketing opportunities are,
however, limited. A spokesperson for Philip Morris Asia says, "Print,
radio and television advertising are banned nationwide. Outdoor
advertising is permitted only with prior approval, and is banned in over
70 local jurisdictions."To get the word out in big cities, foreign
manufacturers often sponsor events and parties at nightclubs. A common
sight on Beijing's San Li Tun Bar Street, a street of night spots for
Beijing's middle and upper class, are the "cigarette girls." Attractive
young women dressed in cigarette company logos pass out free samples,
lighters and other promotional items to patrons.

LOOKING AHEAD. Foreign cigarettes are still small players in China's
cigarette market. Dividing the pie of 51 billion sticks between BAT,
Philip Morris, Japan Tobacco, Reemtsma, RJRI and Rothmans International
leaves everyone just a tiny piece. Furthermore, foreign manufacturers have
to contend with import quotas, an import tax of 218 percent, and the STMA.
Smuggling and counterfeiting of foreign cigarettes are rife.

The STMA is out to protect its own. Even with WTO accession, China's STMA
will remain the dominating force of China's tobacco industry and even if
profits don't come overnight, with a market the size of China there will
always be opportunity. Commenting on his company's situation, Stettler of
RJRI sums up, "We are extremely lucky to have what we have. We have had
immediate returns with our joint venture and we are building guanxi for
the future."—C.B.